Small Banks Merging to Save Themselves

Last month, Mark Sunshine from Veritas Financial Partners made an interesting comment in an interview with Axial, noting that “the largest predictor of bank profitability last quarter was size.” Since the article was published, 13 banks have either completed or announced merger agreements. None of them were larger than $2B in total size.

Ryan Harrell, Senior Vice President at CertusBank, explained that a number of factors are leaving smaller banks less profitable and are leading to the recent rise in bank mergers and acquisitions. CertusBank was created through the FDIC shelf bank program two years ago before raising a $500M private placement. Since then it has used the capital to acquire four banks, two mortgage companies, and an SBIC, resulting in a $2B full-service institution. And they’re still buying. Certus Bank not only understands why small banks are being acquired, they’re growing through acquisitions in order to circumvent many of the problems smaller banks face.

Banking is Simple

According to Harrell, banking isn’t all that complex. Banking comes down to three factors: administrative and regulatory overhead, interest earnings on loans, and ancillary product sales. The primary reasons why larger banks are more profitable than smaller banks is because they can better handle regulatory burdens and because they are able to sell more ancillary products to bigger clients. Interest earnings on loans have become a commodity for most banks, especially if the bank has the ability to generate income in other parts of the business relationship.

“Most banks use a RAROC, the risk adjusted rate of return, to determine the interest rate that will be offered on a given loan,” Harrell explained, “The RAROC might say the loan spread should be 250, but we can get ancillary profits so that allows us to be more competitive on the interest terms to compete with larger banks.” Smaller banks, without ancillary services like investment banking, structured products, derivatives, FX, and mortgages have to depend on making their income from less competitive interest spreads. Smaller banks also have a harder time raising capital from Wall Street, leading many to become ‘zombie banks’ that lack the capital to swallow larger loans, or any loans at all if they’re living off of interest repayments alone. Growth for many becomes anemic at best.

Smaller Banks Burdened by New Regulatory Hurdles

Beyond interest rates and ancillary product disadvantages, both of which existed before the financial crisis, the real change is in regulation. As Harrell explained, “after 2008, the FDIC started regulating banks much more heavily. We’re seeing a different breakdown in how each size is monitored. Banks that are smaller than $1B are monitored one way, $1-5B another way, $5-50B differently, and $50B+ start becoming special cases. Banks that are less than $1B are going to have a hard time surviving because of the regulatory burden.” And so many of the transactions, like the $1.4B merger of Cullen/Frost and WNB Bancshares in West Texas, are being done in order to create economies of scale while at the same time pushing banks into new regulatory brackets.

With Dodd-Frank only 1/3 implemented, many of the regulations that will affect banks of all sizes are still opaque. Some commentators have noted that Dodd-Frank represents more legislation for banks than all of the previous legislations back to the Great Depression, increasing the regulatory burden dramatically on all banks. Smaller banks can create some buffer on the regulatory effects and spread the costs among more loans by merging. The First National Bank and Bank of the Ozarks merger was a perfect example. First National had been under a regulatory agreement with the Office of the Comptroller which required many additional employees for compliance, all of which were unnecessary after the merger. As smaller banks combine, the cost savings for compliance can be dramatic.

Regulations aren’t the only cause

But the recent wave of mergers isn’t only explained by the unprofitability of smaller banks or increased regulations. Three other major contributing factors are adding to the rise:

Banks selling assets acquired through FDIC guarantees
During the depths of the financial crisis, the FDIC set up a temporary guaranteed liquidity program that allowed banks to acquire distressed assets with an FDIC backstop. Many thought these assets would eventually become part of profitable bank portfolios but have found the returns failing to live up to expectations. Some of the mergers, like Essex Bank’s recent sale of four Georgia branches to Community & Southern Bank, fit this bill perfectly. Moving the assets to a local bank where they are a better fit simply makes more sense and removes the problem from Essex’ books.

Many banks still dramatically undervalued
Harrell noted that mergers are also happening because banks are at historical low enterprise to book ratios. As he explained, “The other component is the book values and how they’re traded. Usually valuation has been in the range of 2 or 2.5x book value for a bank. Now you can buy a bank for 1x book. We’re seeing a real undervaluing in the banking industry and investors are buying banks at 1x hoping values will return to 2x book later.” In some cases, the return of value has happened already. As the WSJ found, some of the private equity investments in banks during the crisis have already returned as much as 35% IRR for the groups that backstopped performing, but in trouble, banks when they raised money in 2008-2010. For other investors, the feeling is that enough time has passed after the crisis to understand which banks are worth longer-term investments and which would end up being an anchor on the rest of a banking portfolio.

Bank owners tired after saving their banks
And finally, as happens in many industries after crisis or cycle events, some of the owners and executives who fought to save their banks over the last few years are  just tired. Dory Wiley, CEO of Commerce Street Capital which represented 9 bank mergers in the first half of the year, commented to the Dallas Business Journal that many bank executives are “fatigued” and just want out. Often lacking succession plans, the best option for many banks has been to merge or sell.

Smaller banks are not yet entirely dead, but their profitability has been declining dramatically. Without access to larger pools of capital or profits from ancillary product sales, the new regulatory burdens are putting their future viability at risk. For investors and business owners, more and more may end up turning to alternative lenders, including SBICs and mezz lenders, as smaller banks become unable to offer the loans they have in the past.